It is ironic that outgoing (resisting the great urge to snark) Chairman Gary Gensler repeatedly argued that one of the main benefits of the Frankendodd clearing mandate is that it would reduce the interconnectedness of the financial markets, especially interconnectedness through derivatives contracts. Now he has pushed through a regulation that mandates an interconnection among major financial institutions via a derivatives channel: the lines connect derivatives CCPs to major banks. I have long pointed out that Gensler’s claim that clearing would reduce interconnectedness was grossly exaggerated, and arguably deceptive. Instead, I pointed out that the mandate would reconfigure-and is reconfiguring-the topology of the network of connections between financial firms. What the CFTC has done is dictate what that form of interconnection will be. This particular dictate is extremely problematic.

A CCP needs access to liquidity in the event of a default of a clearing member. The CCP needs to pay obligations to the winning side of the market, in cash, in a very tight time window. Failing to make these variation margin payments could impose financial distress on those expecting the cash inflow, and more disturbingly, call into question the solvency of the clearinghouse. This could spark a run in which parties try to close positions in order to reduce exposure to the CCP. Given that this is likely to occur in highly unsettled market conditions, such fire sales (and purchases) will inevitably inject substantial additional volatility into price that can exacerbate pressures on the clearing mechanism.

A CCP holding Treasuries posted as IM by the defaulting CM can sell them to raise the cash. Alternatively, it could repo them out. During most periods of financial turbulence-and financial crisis-which is likely to be either the cause or effect of the default of one or more large CMs, there is a “flight to quality” and Treasury security prices rise and there is a rush to buy them by investors seeking a safe haven. Moreover, under such circumstances the Fed will perform its lender of last resort function, and readily accept Treasuries as collateral: even if CCPs could not access the Fed directly*, they could access it indirectly. Thus, in “normal” crises, Treasuries should be highly liquid, and a ready source of cash that can be used to meet variation margin obligations.

Put differently, from a liquidity perspective, Treasuries are a negative beta asset: they become more liquid when overall market liquidity declines-or verges on collapse. This is a highly desirable attribute. Another way to characterize it is that from a liquidity perspective, Treasuries have right way risk.

Bank lines are very different. Banks become stressed during crisis situations, and face a higher risk of being unable to perform on credit lines under these circumstances. (Indeed, what if the defaulter is one of the suppliers of a committed line?) Banks fighting for survival but which can perform might try to evade this performance during stressed market conditions, which in a tightly coupled system (and clearing is a source of tight coupling) can be extremely disruptive: a few minutes delay in performing could cause a huge problem. And if the banks do perform, doing so poses the substantial risk of increasing their risk of financial distress. That is, committed lines are positive beta from a liquidity perspective: that is, they pose wrong way risks. If drawn upon, these lines can be an interconnection that is a source of contagion from a derivatives default to systemically important banks, precisely at the time that they are least able to withstand the shock.

In the event, a CCP that does collect Treasuries as IM can likely use these right way assets to raise the cash need to meet its obligations, and can avoid drawing down on its committed line. But that would mean that the committed line is superfluous, and imposes unnecessary costs on the CCP, and hence on the users of the clearing system.

I also conjecture that having met its liquidity requirements with a committed line, pursuant to the CFTC reg, CCPs would have a weaker incentive to take Treasuries as collateral, and a stronger incentive to permit the posting of lower quality assets (or incentivizing such posting by reducing haircuts assessed to such collateral) for IM. This would mitigate the cost impact to users that results from the CCP having to secure the committed line, and pay for it (the cost being passed onto the users), thereby reducing the loss of trading/clearing volume and the associated revenues. This would increase the odds that the line will be drawn on (because the lower quality assets pose a substantial risk of becoming illiquid during a crisis situation-they embed wrong way risk too). I’ll have to think this through more, because the situation is somewhat complex: it depends on the pricing of the line, which will depend on the likelihood it will be drawn against, and the market conditions at the time it is. This will depend in part on the quality of collateral that the CCP collects. I’m not sure of what the equilibrium outcome will be, but I suspect that mandating the obtaining of lines will undermine incentives to demand the posting of high quality collateral. If it does, this is a bad outcome that increases wrong way and systemic risks. If it doesn’t, then the cost of the lines is superfluous and a burden on clearing and derivatives trading.

There is one scenario in which Treasuries would not be good collateral: if the financial crisis (and default of a CM or CMs) was the result of a fiscal crisis in the US, or a default (real or technical) of the kind feared during the last (but the last, most likely) debt ceiling standoff. But that’s an Armageddon scenario in which banks are likely to be highly stressed and unable to perform, or in which they would incur exceptional and arguably existential costs if they did. Put differently, there’s likely no good source of liquidity in this scenario, and the CFTC rule will hardly make a difference.

In sum, it is highly unlikely that bank lines are a better source of liquidity, especially under crisis situations, than Treasuries. Indeed, they are plausibly worse, and actually create an interconnection that can transmit a shock to the derivatives market (and the CCP that clears it) to systemically important banks: this is the exact opposite of what clearing was supposed to achieve. The cost of the lines, which is likely to be substantial, particularly given their necessary size, is a deadweight burden on the markets: all pain, no gain.

Other than that, the rule is great. And a fitting parting shot from Gensler.

* Frankendodd makes it difficult for US CCPs to obtain Fed liquidity support. This is a serious mistake that could come back to haunt us in some future crisis. To work effectively, the LOLR must be able to direct liquidity to where it’s needed, quickly and efficiently. CCPs could be a major source of liquidity demand in future crises, which makes isolating them from the Fed highly dangerous, and the invitation to an ad hoc response in some future crisis.

Yes, the ability to repo Treasuries against the Fed would be probably the best way to do it, given the tight window for the daily margining process. One needs to solve this first (without any hint of a problem given to the market) and worry about the rest later.

This banning of Treasuries is about as stupid as stupid can be: as you point out, it is demanding money from those institutions that are probably most stressed, denies the use of the most liquid of securities, and in the environment when treasuries wouldn’t be money good, what the hell else would be? What are we going to believe, that FHLB/TVA/Exim/FHLB/ whatever paper is good? That GNMA, FNMA and Freddie are still good? Ridiculous.

And to add injury to already insulted injury, they close the only waste disposal chute for illiquid assets, the Open Window.

Breathtaking in its complete – words fail me, at least in a SFFV kind of way.